Legislated Risk Retention Is No Substitute for Good Underwriting: Report

Both the House bill for financial regulatory reform, which passed the chamber in December by a narrow 223 to 202 vote, and the draft Senate bill currently being debated include across-the-board risk retention provisions[IMAGE]for home mortgages. The idea is to ensure lenders have more ""skin in the game"" so to speak, to prevent the risky lending behavior of the recent housing boom that so many economists and lawmakers blame for the industry's crisis and the ensuing recession.

But according to a new study by the ""Community Mortgage Banking Project"":http://www.communitymortgagebankingproject.com (CMBP), such mandated risk retention is ""no substitute"" for good underwriting and strong documentation standards. The analysis of the loan performance data in the study shows that the application of a handful of common sense underwriting standards improves loan performance dramatically.

CMBP says its findings make it crystal clear that policymakers should focus their efforts on ensuring financial reform legislation has significant incentives for home mortgages with strong underwriting standards, rather than sweeping risk retention provisions that treat risky and non-risky mortgages equally. Industry analysts and some regulators have recently raised concerns that risk retention is a blunt tool that could significantly raise the cost of home mortgages.

Examining more than 20 million loans made between 2002 and 2008, ""the CMBP study"":http://www.communitymortgagebankingproject.com/Press.html found that riskier mortgages performed three times worse, as measured by loans that were 90 or more days delinquent.

The analysis measured the difference in default rates between higher risk loans and traditionally underwritten, back-to-basics loans during the recent housing cycle.

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Qualified mortgages - that is, traditionally underwritten mortgages - performed 2.6 times better prior to the boom in 2002, and 3.25 times better at the peak in 2005. Qualified mortgages performed significantly better in each of the nation's top 25 metropolitan areas.

""This study confirmed what has long been suspected,"" said James Bennison, SVP of strategy and capital markets for ""Genworth Financial's"":http://www.genworth.com U.S. mortgage insurance business, which solicited the study in collaboration with CMBP.

""Traditional underwriting standards, including full income documentation and straightforward loan features, yielded dramatically fewer defaults,"" Bennison explained. ""Policymakers should be looking for ways to encourage liquidity for this type of lending. Unfortunately, the across-the-board risk retention would increase its cost and reduce its availability.""

The Senate Banking Committee is currently in the process of marking up its financial reform legislation. The committee is expected to consider a proposal to impose across-the-board risk retention requirements for all loans sold in the secondary market. It would require the SEC and the federal banking agencies to issue regulations requiring creditors and issuers of asset-backed securities to retain 10 percent of the credit risk on whole loans and securitizations.

CMBP says the provision would impact both traditionally underwritten mortgages as well as riskier mortgages, imposing additional costs on even the most responsible borrowers using back-to-basics mortgage products.

Glen Corso, managing director of CMBP, said risk retention provisions are a reasonable approach for exotic mortgages that carry higher risks of default. That is not the case, however, for traditionally underwritten mortgages such as the ones offered by community-based mortgage banks, local bankers, and credit unions, he said.

""This study demonstrates why Congress should be careful not to impose an arbitrary risk retention requirement on all loans sold in the secondary market,"" Corso added. ""Across-the-board risk retention will unnecessarily and unfairly raise costs on creditworthy borrowers seeking products that are demonstrably lower risk.""

CMBP has urged the committee to exempt low-risk ""qualified mortgages"" with strong underwriting and documentation standards and safe product designs.